the commercial mortgage loans and cmbs markets: … · the commercial mortgage loans and cmbs...

Chapter 1

The Commercial Mortgage Loans andCMBS Markets: Legacy and currentpositions

Andrew V. Petersen,

Partner and Practice Area Leader-Finance, K&L Gates LLP

1.1 Introduction

Commercial real estate (CRE) is a tremendously important asset, as thecontent of this book will discuss. However, the CRE lending and com-mercial mortgage-backed securities (CMBS) markets are, at the time ofwriting, largely unrecognisable to the markets that existed on the publica-tion of the first edition of this book, published in 2006. Between the firstedition1 and the second edition, published in 2012,2 such markets havewitnessed seismic structural shifts. Numerous financial institutions withstrong histories were consolidated or were nationalised and, through thechaos of the GFC, CRE and the CRE capital markets had a visible presencethroughout, with nearly all real estate values across the globe sufferingunanticipated catastrophic declines.

The provision of capital to the CRE industry, which tends by definition tobe very capital intensive and of a longer-term nature was, during the boomperiod up to 2007, mostly funded by balance sheet banks using relativelyshorter-dated funds, thus allowing them larger spreads through effectivelytaking maturity transformation risk. This position could not continueindefinitely. Due in a large part to the deterioration that began in the USsub-prime mortgage market in the second half of 2007, this position ledthrough contagion, interdependence and interconnection, to a deep crisisfor the global securitisation markets, across all asset classes, which devel-oped in 2008 and in the subsequent years quickly morphed into the GFC.

With the GFC came a decrease in leveraged M&A transactions, falling shareprices, a weakening of the global economy and the shutting down orfreezing of the global real estate capital markets, ending the seemingly

1 A.V. Petersen, Commercial Mortgage-Backed Securitisation: Developments in the EuropeanMarket, 1st edn (London: Sweet & Maxwell, 2006).

2 A.V. Petersen, Commercial Mortgage-Backed Securitisation: Developments in the EuropeanMarket, 2nd edn (London: Sweet & Maxwell, 2012).

1

unstoppable growth of issuance in European and US CMBS markets wit-nessed prior to the summer of 2007. This development was not a cyclicalchange, as had occurred in the past, but a major structural change, givingrise to questions over the viability of the CMBS ‘‘originate-to-distribute’’model, based in part on structural weaknesses revealed in the securitiesthemselves. Such questions, dealt with throughout this book, will also needto be addressed post 2016, as many believe that the impact of this structuralshift, still evident at the time of writing, may persist until 2020 and beyond.

Given this backdrop, and the backdrop of the UK’s vote for Brexit in theJune 2016 referendum on EU membership (the consequences of whichcontinue at the time of writing) the markets witnessed an unprecedentedlevel of intervention by the world’s central banks and state bail-outs of thefinancial and capital markets, and this third edition will consider theongoing effect of such interventions and their effects on these markets in thecontext of a post GFC world. In doing so, this Chapter will consider thelegacy markets for CRE financing and CMBS and will examine the marketsat the time of writing. In doing so, it is necessary to go back in time toexamine the evolution of the CRE and CMBS markets in an effort tounderstand and to determine whether European CMBS will, going forward,once again be an important source of funding and risk diversification tooland resurge from the form in which it exists at the time of writing. Thus,when we consider the legacy European commercial mortgage loan andCMBS markets that exist at the time of writing, we can split such analysisup into three separate periods: up to 2007, 2007 to 2012 and post 2012.

1.2 The European CRE loan and CMBS markets prior to2007

The first edition of this book chartered the introduction and development ofthe innovative CMBS product in Europe up to 2006. During this period, as aresult of technological improvements and the lowering of global investmentbarriers that freed CMBS from the restrictions of US REMIC rules, thedevelopment of the product proved remarkable in its ability to address theneeds of borrowers, loan originators and investors, in a way few wouldhave thought possible. This transformation resulted in an explosion ofissuance, as the CMBS market in Europe reached e46 billion (more thandouble the total for 2004), peaking at e65 billion in 2007. This issuance cameoff the back of a boom in CRE financing, fuelled by an overheated CREmarket, fostered by the availability of plentiful and cheap funding, coupledwith relatively low capital requirements that established real estate as aglobal asset class in its own right.

The European bank lending sector was, up to 2008, the key and biggestprovider of financing to the CRE market, providing around 90% of thefinancing to the sector as banks with significant balance sheet capacity (but

Commercial Mortgage Loans and CMBS: Developments in the European Market

2

not strength, as it turned out) grew their exposure to real estate sub-stantially during the period 1997 to 2007. This was predominantly as aresult of falling interest rates which stimulated demand for real estate fol-lowing the technology market crash and dotcom bust of early 2000s asinvestors sought solace in longer-term assets that effectively hedged interestrate risk. During the period from 1997 to 2007, given the relatively lowdevelopment of other forms of financing, CRE financing was one of thefastest growing lending classes for banks, particularly in the UK, Germany,Ireland and Spain. The largest CRE lenders were made up of UK, Germanand Irish banks (in each case lending both domestically and inter-nationally). Spanish banks also generated a large CRE exposure, althoughprimarily domestic (see further the Spanish lending section contained inChapter 18). Prior to this period, commercial and residential real estate debtwas held on the balance sheets of mortgage lenders, such as banks, buildingsocieties and insurance companies. To the extent that a secondary marketexisted for this debt, it was largely a club syndication and participationmarket. Securitisation through the issuance of CMBS played a small (his-torically around 10–12% the total outstanding debt in the sector), butmeaningful, role in funding European CRE throughout this developmentand it is important to understand its origins.

1.2.1 The birth of commercial mortgage-backed securitisation

Whilst the US claims to be the birthplace of CMBS, securities, in the form ofEuropean mortgage bonds, have existed in Europe for over 200 years.Nonetheless, it is true that CMBS in the modern form ultimately did notbecome popular in Europe until after the 1980s following the widespreadacceptance in the US marketplace where many of the legal structuralfoundations of the modern CMBS market were put into place, paving theway for the growth of the modern CMBS industry. Such growth was basedon the changing dynamics of real estate lending that had its origins in the1970s, particularly as US government-sponsored enterprises, such as theFederal National Mortgage Association (Fannie Mae) and the Federal HomeLoan Mortgage Corporation (Freddie Mac) began to facilitate increasinggrowth in home ownership by guaranteeing mortgage-backed securitiesbacked by portfolios of US mortgages.

CMBS in the US received a further catalyst for growth with the advent ofthe savings and loan crisis of the late 1980s. The crisis led to a seminal eventin the development of the modern US CMBS industry, with the passage ofthe Financial Institutions Reform, Recovery and Enforcement Act (FIRREA)in August, 1989. Among other things, it imposed stricter capital standardson regulated commercial lenders and created the Resolution Trust Cor-poration (RTC). The RTC was charged with resolving failed thrift institu-tions and disposing of the assets of these failed institutions. In the early1990s, the RTC, and later the US Federal Deposit Insurance Corporation (theFDIC), began to reduce the inventory of assets that they had acquired fromfailed depository institutions during the savings and loan crisis. The biggest

The Commercial Mortgage Loan and CMBS Markets: Legacy and current positions

3

portion of the RTC’s inventory consisted of a portfolio of mortgage loans,which by August 1990 was estimated to be more than US $34 billion thathad been originated and held by depository institutions that the RTCcontrolled. It was quickly realised that selling those loans one by one wasneither efficient, nor, in the final analysis, even achievable. As the marketfor mortgage-backed securities had developed dramatically up to this time,the RTC, in a significant step in the evolution of the mortgage capitalmarkets, turned to the then novel concept of private-label securitisation ofassets that did not conform to the Fannie Mae or Freddie Mac underwritingstandards as a way to dispose of this overhang of now publicly ownedprivate debt.3

The success of the RTC’s CMBS programme resulted in private-labelmortgage conduits bursting forth in the early 1990s as a way of funding andsecuritising vast pools of commercial and multi-family loans. It is duringthis period, through financial innovation, that the alchemy of securitisationtruly prospered as the ‘‘originate-to-distribute’’ business model took holdwhere mortgages were originated with the sole intention of distributingthem or selling them on in the market shortly after being written, therebypassing the risk of default to another financial institution. Such alchemyallowed risky mortgage assets to be mixed in a melting pot of potions to beturned overnight into highly-rated investment grade assets based on a widerange of investor demand and appetite. Meanwhile, the European secur-itisation markets, whilst lagging behind the developing market in the US,slowly metamorphosed into a European securitisation industry based onthree types of securitisation methods:

. ‘‘On-balance sheet securitisation’’, such as covered mortgage bondsand Pfandbrief-style products;

. ‘‘Off-balance sheet pass through’’ securitisation, where assets aretransferred to a trustee for the sole purpose of issuing asset-backedsecurities; and

. ‘‘Off-balance sheet pay through’’ securitisation. This development andgrowth was as a result of the diversity of the European markets interms of the types of underlying assets, types of security and theapplicable taxes, regulations and laws that permeate throughoutEurope.

The introduction of the euro currency towards the end of the 1990s resultedin a reduction of the currency translation risks of cross-border transactions,translating into an increase in issuance fuelled by strong investor demand,which formed the basis for the creation of a relatively large European MBS

3 See further Ch.1 of the 1st edn. The RTC’s famous ‘‘Series C’’ transactions marked the firsttime that commercial mortgages were packaged and securitised in large volumes. Theseprogrammes not only helped to resolve the overhang of the savings and loan crisis, but alsocreated standard templates for securitisable loan terms, securitisation structures, loan ser-vicing conventions, property information reporting templates and the like, paving the wayfor the growth of a vibrant commercial mortgage conduit securitisation industry.


4

market. A UK-centric, fixed rate market in the late 1990s quickly developed.During this time, CMBS transformed the CRE market. What was initially anisolated, self-contained business funded by domestic (and often geo-graphically local) banks and insurance companies, investing a fixed ‘‘realestate’’ allocation of capital into the CRE markets for portfolio purposes andholding those mortgage loans on their balance sheets to maturity, trans-forming itself into a business funded by the broad global capital markets.

By the late 1990s, fixed income investors invested in rated bondsthroughout the capital stack, up and down the risk curve enabling thespread of risk. A growing number of boutique, high-yield real estate playersfurther emerged to invest in the below investment grade segment of the riskcurve. CMBS led to an enormous increase in the availability of finance andbecame a major driver of economic growth in western markets. However,the autumn of 1998 witnessed the Russian rouble debt crisis which, whilstshaking the industry to its core, also matured the industry,4 such that (for atime) there were tightened underwriting standards throughout the earlyyears of the 2000s, a period which also led to a high-yield market for sub-ordinate tranches of CRE loans.5

In the UK, prior to 2004 listed real estate companies or corporates were themajor issuers of CMBS as it was mainly used as a financial or capital raisingtool; a means for such entities to borrow directly from the capital markets tofinance investments more efficiently on longer terms than borrowingdirectly from banks. CMBS proved attractive due to capital efficienciesresultant from the CMBS product with margins offered through a CMBSfinancing, often lower than through conventional bank debt funding. Thus,a price arbitrage developed between bank lending and CMBS lending. Thenfrom 2005 to 2007, following the birth of banks’ conduit programmes(described below), CMBS began lending in increasing amounts, direct tohighly geared CRE investors, such as private equity funds and propertyfunds, leading to a dramatic shift in the use of CMBS from a long termfinancing to a shorter term funding method. The loans originated by theseprogrammes were often set up by investment banks or commercial banks,which would then deposit the loans to capital markets issuing entities forpackaging and distribution to investors.6 These investors, broadly speaking,saw bonds backed by commercial mortgage debt, not as an isolated‘‘alternative investment’’ but simply as one among many core investmentopportunities, which were pursued with more or less vigour dependingupon perceptions of relative value. This led to a range of assets beingfinanced through securitisation conduit programmes, such as operatingbusinesses made up of pubs, hotels and nursing homes through to offices,retail properties and industrial properties. With this development, theCMBS industry morphed into a major source of capital, with 75% of all

4 See further Ch.1 of the 1st edn.5 See further Ch.5.6 See further Ch.3 of the 1st edn and Ch.4 herein.


5

outstanding CMBS bonds that still exist at the time of writing, issuedbetween 2005 to 2007, mostly all through conduit programmes. Thusthrough CMBS, CRE and its funding depended, in a very material way,upon direct access to the capital markets. It is worth setting out what exactlythe CMBS product consists of for those readers unfamiliar with the product.

1.2.2 Key features of CMBS

CMBS is largely a mechanism for capital transfer established on a metho-dology of channelling capital into real estate debt based on cash flowsgenerated by separate pools of commercial mortgages through the creationand issuance of securities. This methodology, based on an indirect realestate investment, is a means of providing liquidity to the markets byissuing securities whose payments are backed by illiquid real estate. Inessence, illiquid assets are converted into securities that can be sold toinvestors, through a product, designed to spread risk, through the methodof pooling and repackaging of cash-flow producing commercial mortgageloans by mortgage originators, usually in the form of off-balance sheetvehicles in the form of newly formed special purpose vehicles (SPVs). TheSPVs issue securities backed by the CRE loans that are then sold to investorsin the global capital markets. Instead of requiring the originator to hold allof the credit risk of a CRE loan until maturity, thereby inefficiently trappingcapital of the originator, CMBS provides the originator a way of selling theCRE loan upon origination and using the funds received to originate furtherloans. The process produces fixed income fees for the bank through thecreation, sale and underwriting/arranging of the product, and, on occasion,at the same time reducing the mortgage originators’ capital requirements/capital relief. The process and its economics, will be discussed further inChapter 4.

The move in the late 1980s and early 1990s to securitise US mortgage debteffectively remedied one of the primary impediments to real estatebecoming a global asset class, that of illiquidity, at the same time serving asa useful credit portfolio risk management tool for CMBS originators. Cashflows from whole loans can be (i) isolated from the individual whole loansand reassembled in a number of ways (based on investor demand) to payprincipal and interest (in normal market conditions at a lower amount thanthe rates received from the borrowers, thereby providing additional incometo the CMBS originators), and (ii) stratified by interest rate, risk and dura-tion, thereby boosting the volume of lending available for CRE, via atradeable security that provides investors with an income stream backed byreal assets. Such investor demand drives the value of the sum of thesecurities to equal or exceed the par amount of the loans backing thesesecurities.

A very important feature of CMBS is the dispersion of risk through thetranching of credit risk based on subordination, so that the pool of mortgageassets (together with any credit enhancement) can effectively be tranched


6

all the way from triple-A rated securities to non-investment grade securitiesthat bear the first loss of risk on the assets in the pool. The securities in aCMBS are rated by international credit rating agencies (CRAs),7 such asMoody’s, Standard & Poor’s, Fitch Ratings and DBRS, based on a metho-dology which recognises the different levels of risk, return, order of pay-ment and degree of credit support. The credit ratings proffered by the CRAsbecame, over time, a crucial indicator of risk as investors relied on suchratings as they themselves were often not in a position to evaluate thequality of, or risk factors associated with, the underlying assets. Indeed,often investment criteria for senior tranche investors were based on the factthat two of the three largest CRAs had provided the same rating and thusan element of reliance of CRAs undertaking the task instead of investorstook hold.

By creating tranched capital structures for investments in pools of mortgagedebt, CMBS transactions permit investors in senior tranches ranging fromtriple-A, with the first claim on payments (thus reducing risk but alsoproviding a lower return), to obtain highly-rated exposures to diverse poolsof financial assets at a yield greater than that for comparably rated corporateor sovereign debt. Whilst investors in subordinate tranches (the so-called‘‘first loss’’ piece, as these notes are the first to absorb losses and conse-quently receive the highest rate of returns), only receive payments once thesenior tranches have been paid (i.e. based on a waterfall principle), suchinvestors can obtain leveraged exposures to diverse pools of financial assetswithout the risk of margin calls.

Such tranching led to the investor base for CMBS becoming highly targetedbased on differential risk-return appetites. Treasury departments of banks,structured investment vehicles (SIVs), asset backed commercial paper(ABCP) conduits, insurance companies and pension funds, were the majorparticipants in the most highly-rated tranches, due to many of these entitiesbeing required to only hold highly-rated securities, which presents the riskof a forced sale in the event of a rating downgrade of the triple-A notes. Thedrive for these institutions into senior CMBS tranches was based on theneed for a return on a product with triple-A credit ratings. That attractedsimilar high ratings as compared to government bonds or treasuries, butbecause interest rates were at historic low levels, offered much lower yields.On the other end of the scale, real estate investors, hedge funds and otheropportunistic high yield investors with a high tolerance for risk or a keenunderstanding of the underlying real estate assets, invested in the mostsubordinate tranches that provided credit support for the more seniortranches. The participation of SIVs and the ABCP conduits, as leveragedbuyers of CMBS, proved controversial, as they engaged in arbitrage byfunding their investments through issuing short-term debt, by way ofABCP and repurchase or ‘‘repo’’ agreements or arrangements at low

7 See further Ch.14. for a discussion of the role of the rating agencies in commercial mortgagelending and the wider debt capital markets.


7

interest rates and then buying CMBS longer-term securities that paid ahigher rate of interest. SIVs were thus highly-leveraged vehicles, mainlyheld and treated as off-balance sheet by banks subject to capital require-ments in relation to their balance sheets (as the banks had no direct claim tothe bonds). As banks wanted to take on more debt to make the returns thatMBS offered, the banks made such investments through SIVs and ABCPconduits. As soon as the ability to raise short-term funding in the marketdisappeared with the advent of the liquidity crisis, the SIVs were eitherliquidated (to the extent they were allowed to do so) or brought onto thebalance sheet of the banks to protect and preserve the bank’s reputation andpositions in the market, thereby rendering them unable to purchase CMBSbut more importantly still keeping the risk of default within the bankingsystem. This effectively eradicated a large section of the investor base and asbuyers for the product disappeared, the CMBS market effectively closed inthe second half of 2007.

1.3 The CRE market: 2007 to 2012

Between 2007 and 2012, the CRE market witnessed a severe cut back frombank lenders, due to the uncertainty of value of the assets they had lentagainst during the boom years. Moreover, regulatory pressures surround-ing the banks’ capital and its use and a general contraction in the inter-banklending market, with bank lenders less than enthusiastic to lend to eachother, further contributed to such cut back. As a result, banks continued toshrink their balance sheets and the shadow banking sector (discussedbelow) continued to reduce their exposure to real estate. Further, the valueof the assets held on the balance sheet of banks continued to cause concern,as one important consequence of the examination of such assets in themarket that developed during this period was the increasing difficulty ofvaluing such assets. Such difficulty also highlighted tensions with inter-national accounting standards, particularly the ‘‘fair value’’ system thatrequires banks to mark the value of their assets to market price. Post 2007,this resulted in banks and other holders of real estate debt marking valuesto a virtually non-existent market. When market value is the price that afair-minded buyer is willing to pay to a seller that does not need to sell,there is a real question raised as to how one values the assets held onbalance sheet that cannot be sold at any price because the market for suchassets has effectively closed down. This problem was recognised by theBasel Committee, which in 2009 issued guidelines to banks to allow flex-ibility in marking asset values to illiquid market valuations, particularlywhere one or more of the transactions (i.e. asset sales) have occurred at lessthan expected value due to illiquid market conditions.

Overall, the CRE sector received a limited amount of financing from CMBSmarkets during 2007 to 2012. Most of the CMBS bonds not able to besecuritised, due to the shutting down of the CMBS markets, were retainedby banks and used to obtain liquidity from the Bank of England (in the UK)


8

and the European Central Bank (ECB) (throughout Europe). Further, themarkets witnessed a contraction of lending against CRE by other creditproviders such as funds, hedge funds and other institutional investors, theso-called ‘‘shadow banking’’ sector. It is estimated that the shadow bankingsystem comprised in excess of 80% of the total credit provided in the USeconomy prior to the financial crisis of 2007–08. Once the short-term moneymarkets and CMBS markets effectively shut down in 2007–08, the shadowbanking system shrank dramatically with important consequences. Inparticular, the declining profitability of the funds (particularly hedge funds)caused in some cases a dramatic rise in redemption requests from investors.Faced with a large number of redemption requests, some funds were forcedto liquidate large portions of their CRE debt portfolios, in many casesthrough forced sales at well below book value for the assets (a process akinto the one witnessed immediately post the UK’s vote for Brexit in the June2016 referendum on EU membership). This had a knock-on effect on thebroader CRE and CMBS markets by contributing to a general decline invalue and liquidity.

1.3.1 European CMBS market between 2008 and 2012

In the UK, between 2008 and 2012, there were eight CMBS transactionsissued. This contrasted with the period from 2004–07 where there werehundreds of new issuances. These included transactions from DeutscheBank’s DECO platform in 2011 and 2012, true sale securitisations of theChiswick Park and Merry Hill loans and Vitus German Multifamily deal.8

The other securitisations were from two corporates that used CMBS to raisefunding totalling £3 billion. Tesco Plc brought four CMBS issues to themarket, totalling £2.64 billion, backed by rental payments from propertiesoccupied by Tesco Plc. Land Securities Plc issued £360 million of CMBSbacked by rental payments from a UK government body. These issuanceshad several common characteristics that appealed to institutional investors:(i) they were single tranches with no subordinate debt; (ii) they were backedby investment grade credits; (iii) they carried fixed coupons; and (iv) wererelatively long dated, with maturity dates ranging from 2027 to 2040. Assuch, they resembled investment grade corporate bonds and did notrepresent a true re-opening of the CMBS market, as investors were pri-marily taking credit risk rather than property risk.

1.3.2. Challenges to re-establishing a viable European CMBS market

Re-establishing a sustainable market in CMBS, since the markets wereeffectively frozen during this period, proved challenging. This was becauseCMBS became associated with a number of disadvantages.

Firstly, because of the insistence of CMBS loans being originated to SPVs, tominimise insolvency and other creditor risk, CMBS noteholders, following a

8 See Deco 2011-E5, Deco 2012-MHILL and FLORE 2012–1.


9

default, had to rely on the underlying cash flow generated by the proper-ties, since there was no guarantee against other funds. This led to perfor-mance issues, with some commentators and regulators branding CMBS asbeing ‘‘toxic’’ assets, which contributed to the GFC. In this regard, it isimportant to differentiate between the US and Europe (including the UK).As discussed above, in the US, certain products, such as subprime resi-dential mortgage bonds and Collateralised Debt Obligations (CDOs)9 cre-ated from these bonds, performed poorly through the GFC. Thedelinquency rate of US subprime loans in 2010 rose above 50%. In Europe,however, these same products were not created and the assets backing mostsecuritised products, including CMBS, performed reasonably well duringthis period, with statistics suggesting that the CRE loans that were securi-tised were of higher quality on average than the CRE loans that were notsecuritised in the UK. This theme will be developed further in Chapter 15.

Secondly, being off-balance sheet and existing effectively in the shadowbanking market CMBS historically has not been subject to banking super-vision or regulations, thus creating the possibility of moral hazard based onweakening underwriting standards. As set out above, CMBS allowed a CREloan originator to avoid the individual credit risk of its borrowers, however,it also (it was argued) reduced the originator’s incentive to ensure theborrower had the ability to repay (based on higher levels of equity) orensuring through strong underwriting, loan terms and provisions (forexample, trapping of cash; interest reserve war chests) based on the realestate providing for payment. Thus, this argument, taken to its extreme,was based on the premise that, where the originator retained no risk andwas compensated merely for making CRE loans, regardless of how wellthose loans were underwritten and without any regard to whether or notthat loan would be repaid, there was no incentive for the originator tomaintain strict underwriting standards (so called ‘‘covenant light’’ loans),leading to a shift in focus of the originator from maintaining high creditstandards to generating maximum volume of product. As was witnessedwith the spread of the contagion from a US sub-prime crisis to the GFC, theease by which large financial institutions were able to package up loans intosecurities and sell those securities in the global capital markets allowed therisk of mortgage defaults to spread well beyond traditional mortgage len-ders to investors that may or may not have understood real estate and therisk of having an indirect investment in it.

Finally, there was during the period of 2008 and 2012, and continues (to alesser extent) at the time of writing, a considerable amount of overhangingCRE debt in need of refinancing. This is due to the fact that CMBS securities(generally around 10 years) are not matched to the underlying loans(typically around five to seven years) raising the risk that borrowers are notable to obtain refinancing at the time of their loan’s maturity dates.

9 See Ch.11 of the 1st edn.


10

1.3.3. Refinancing risk

Given the catastrophic decline in CRE values after 2007, most LTVs on CREloans rose in excess of 100%. This resulted in many borrowers being innegative equity. As most CMBS loans do not amortise (preferring instead asingle repayment bullet at maturity), it was predicted that those high LTVswould persist for many years to come. Thus, whilst it remained the case thatmost UK CMBS and loans continued to out-perform balance sheet loans, itwas predicted that there was in 2012 refinancing risk for CMBS of arounde75 billion, owing to a gradual maturing of existing CMBS. Based on aprediction that up to 50% of all UK CRE that required refinancing might noteven be suitable for CMBS origination (not being standardised enough to betrusted by investors) and with an estimated e25 billion of equity capitaloutflow from real estate markets due to open ended funds terminations, itwas predicted in 2012 that there existed a total financing shortage for theEuropean CRE sector of around e400–e700 billion. Of the £56 billion of UKCMBS bonds outstanding, £27 billion was due to be repaid over the next 10years. These bonds were predominantly of the ‘‘conduit’’ variety, whichwere issued by investment bank programmes from 2005 to 2007, asdescribed above. Given CRE loans tend to have an average duration of fiveto seven years, preceding the peak in CMBS bond maturities in 2014, a waveof UK CMBS loans, totalling about £19 billion, matured in 2012 to 2014. Thistopic will be dealt with in further detail in Chapter 3.

Debt held against UK CRE continued to fall from £228.1 billion in 2011 to£212.3 billion in 2012, a drop of 6.8%.10 The 2012 UK Commercial PropertyLending Market Report by De Montfort University (De Montford Report),found that ‘‘while the overall level of debt was falling and progress hadbeen made in dealing with the distressed legacy debt, there was a long wayto go with between £72.5 billion and £100 billion struggling to be refinancedon current market terms when the debt matures as it has a loan-to-valueratio of over 70%.’’ The 2012 De Montford Report further recognised thatalthough progress had been made in addressing the legacy situation, banksstill faced a significant overhang of pre-recession CRE debt held on theirbalance sheets, with around £51 billion due to mature in 2012 and £153billion—72% of outstanding debt—by year-end 2016.

Bright spots in the 2012 De Montford Report showed loan originations on theincrease and new lenders to the market increasing their market share tocirca 8%. However, this was a mere drop in the ocean compared to the levelof deleveraging—in 2012 Morgan Stanley expected e1.6 to e3 trillion of total

10 See UK Commercial Property Lending Market Report by De Montfort University, whichremains the UK’s largest independent property lending survey (the De Montford Report). In2012, the survey of 72 lending teams from 63 banks and other lending organisations saidthat 2011 started with some optimism for the commercial property lending market,including the first CMBS issue since 2007, but that this changed dramatically during thesecond half of 2011 as the Eurozone sovereign debt crisis heralded ‘‘extremely tough times’’to the economy.


11

loan reduction between 2012 and 2015, as banks endeavoured to increasecapital, recover funding, improve profitability and generally refocus busi-ness models. Morgan Stanley derived this number from the sum of thespecific CRE deleveraging plans already announced by some banks(approximately e300 billion of loans) and it estimated that up to e300 billionof exposure might not be entirely rolled over as banks retrenched andrefocused their business, and thus reduced their cross-border loans orsimply reduced LTVs. To put this into context, this was equivalent to fivetimes the annual real estate transactions between 2008 and 2012 in Europe.11

1.4 The CRE market: 2012 to the present day

Since the second edition of this book published in 2012, there has been anupward trajectory in the CMBS market, although not necessarily in Europe.In the US, lenders issued $94 billion in new loans in 2014 and US CMBSissuance ended 2015 above $101 billion (although at the time of writing 2016is unlikely to reach this amount). There were 16 CMBS transactions issuedin the UK between 2012 and the end of 2015, twice the number in theprevious period following the GFC. Notable transactions included the£450m Intu (SGS) Finance Series 1 and £350m Intu (SGS) Finance Series 3issued as part of a £5 billion programme, the base prospectus of which waspublished in March 2013, the £463m Isobel Finance No. 1 Plc and theWestfield Stratford City CMBS in relation to a £750m loan secured by acharge over Westfield shopping centre in central London.

Some issuances, such as Westfield Stratford City Finance Plc had similarcharacteristics to those post 2008, where issues had single tranches and longmaturity dates were the norm, in order to appeal to institutional investorssince 2012. However, other transactions have been more complex thanduring 2008 to 2012. Few CMBS issued between 2012 and 2015 have had amaturity date beyond 2030; DECO 2013-CSPK Limited for example has anAugust 2019 maturity date. Rates payable on notes have been primarilyfloating, multi-tranched and with varied ratings. Magni Finance DAC, forexample, has five note classes with ratings ranging from A to unrated juniornotes. In addition, Mint 2015 was an example of an unusual multi-currencyCMBS, which issued £251.2m and e131m notes, further to the securitisationof £75m and e30m mezzanine debt in 2014, backed by hotel properties inthe UK and the Netherlands. This suggests some re-opening and recoveryof the CMBS market and an increasing risk appetite of CMBS investors.

More importantly, the refinancing risk caused by the overhang of pre-recession debt, discussed above as identified by Morgan Stanley in 2012,has not been as severe as initially forecast. Moody’s stated in December2015 that ‘‘the much vaunted ‘refinancing wave’ in 2016 and 2017, during

11 See Morgan Stanley’s Blue Paper 15 March 2012 ‘‘Banks Deleveraging and Real Estate—Implications of a e400–e700 billion Financing Gap’’ (the Morgan Stanley Report) p.17.


12

which loans originated with 10-year terms during the 2006 and 2007 pre-crisis peak mature, caused little more than a ripple’’, noting that ‘‘about halfof the original issuance levels have since paid off or defaulted and of theremainder about three quarters appear well positioned to refinance, even if10-year Treasury rates rise by up to 2%.’’ In its CMBS Surveillance MaturityReport for February 2016, Morningstar predicted that the total remainingamount of loans still to mature in 2016 and 2017 is now approximately $150billion—it expects $56.98 billion of CMBS loans to mature in 2016 and $99.88billion in 2017. Morningstar has reported that most CMBS loans originatedbefore the market’s peak of 2006–07 have been able to refinance, and thedelinquency rate is at a seven-year low as at February 2016.12 See furtherChapter 3.

UK CRE loan origination increased from £45 billion in 2014 to £53.7 billionin 2015 according to the 2015 De Montford Report. There has also been acontinuing growth in the market share of non-bank lenders for loan origi-nations, which has increased to 9%, and the market share of insurancecompanies has steadily increased to 16% of the market in 2015. This hasbegun to add diversity to funding sources in the CRE market. CREFC-Europe has endorsed the growing role of institutional capital in addition tobank lending in the CRE debt market as a means of enhancing financialstability, and delivering stable long-term income. The 2015 De MontfordReport will be further discussed in Chapter 15.

This growth in market share has been partly attributable to deleveraging bybanks; by the end of 2014, the CRE loan book of the six largest UK bankshad shrunk by 56% to £68 billion.13 At the time of writing, deleveragingappears to be drawing to a close. The total amount of outstanding CRE debtin the UK at year-end 2015 was £168.4 billion, representing a 1.9% increasefrom £165.2 billion at year-end 2014, and the first increase recorded since2008, whereas it had dropped by 6–10% in each of the preceding fiveyears.14 According to the 2015 De Montford Report (the latest report at thetime of writing), the deleveraging process has been secured by refinancingof assets at lower LTVs and an increase in equity-only CRE investment. Thishas been further supported by rising CRE values. By the end of 2015lending refinanced before the end of 2007 together with new lending beforethe end of 2007 dropped to 15% of the total CRE debt stock in Europe. Thepace of deleveraging between 2007 and the time of writing has variedbetween different countries. Ireland has significantly reduced its exposureand deleveraging in Germany and Spain appears to have decelerated.Spain, for example saw a 34% reduction in closed loan sale transactions inCRE and residential loans between 2014 and 2015. In Italy on the other

12 See CMBS Surveillance: Maturity Report February 2016 Remittance https://ratingagency.morningstar.com [Accessed 24 August 2016].

13 See APL CREFC Europe INREV ZIA ‘‘Commercial Real Estate Debt in the EuropeanEconomy 2016’’ p.28.

14 See Ch.15 and UK Commercial Property Lending Market Report (De Montfort University, 2015).


13

hand, the country’s banks were slow to adopt deleveraging plans and onlybegan significantly deleveraging in 2014; in 2015 it posted e5.3 billion ofCRE and residential loan trades, which was 8.2 greater than in 2014 and 23times greater than in 2013.15

However, 71% of respondents to the CREFC Market Outlook Survey in 2016believed that CMBS spread volatility would be ‘‘somewhat’’ volatile, withgeopolitical events, deteriorating credit standards, and contagion fromvolatility in other asset classes being likely causes of spread volatility in2016. Although 65% of respondents to the 2016 CREFC Market OutlookSurvey expected a total CMBS issuance of between $100 and $125 billion in2016, there was only e885m placed issuance between January and July 2016in Europe compared to e4.25 billion during the same period in 2015 and inthe first quarter of 2016 there was a total of $17.8 billion priced in the US,down 32% against the previous year.

Looking beyond 2016, there therefore appears to be a mixed picture. Inrelation to new issuances, although there are signs of CMBS marketrecovery, heightened volatility may impact CMBS and factors in thefinancial world unrelated to the underlying performance of CMBS maynegatively affect the CMBS market, as will be discussed in the final chapterof this book. Moreover, in relation to maturities, Morningstar projects thatthe borrowers’ ability to pay off CMBS loans on time will become pro-gressively more difficult through 2017, because of lax underwriting stan-dards and estimated net cash flow projections that were never realised.

1.5. Conclusion

As stated above, the European CRE and CMBS markets have undergone adramatic structural shift since 2007 and the central banks that regulate themhave, since the advent of the GFC, faced unprecedented challenges. Such astructural shift has highlighted (as did the Russian rouble crisis of 1998),that in disintermediated credit markets, such shifts and crises can quicklymorph into a GFC, where investors flee to the relative quality of govern-ment treasury securities and where subordinate interests cannot be sold forany price. During the GFC, SIVs (a historic readily available market forCMBS) largely disappeared, and alongside the shifting investor base, ori-ginators’ business models changed—perhaps forever. Given these changes,it is predicted that, at the time of writing, CMBS will remain only a marginalprovider of CRE capital over the medium term due, in a large part, to theseismic shifts that have brought regulatory challenges, such as:

15 See CBRE Capital Advisors ‘‘European Commercial Real Estate Finance 2016 Update’’ andthe Italian NPL Market section in Chapter 18.


14

. Basel III,16 that by increasing the amount of capital financial institu-tions must hold to ensure solvency during periods of financial stress,in turn makes it more costly for such institutions to hold CMBS;

. Article 122a of the CRD, which came into effect in January 2011(replaced in January 2014 by arts 405–409 of the Capital RequirementsRegulation), the so called ‘‘5% skin in the game’’ provisions.17 Bankand insurance investors in all securitisations now need to ensure thatthe transaction originators retain 5% ‘‘skin in the game’’, meaning thatthey retain a 5% interest (first loss or vertical) in every CMBS trans-action they bring to market. The retention rule has not prevented theresumption of primary issuance in funding-motivated products likeprime residential mortgage-backed securities (RMBS) and consumerasset-backed securities (ABS) because originators typically retained anequity interest even before the crisis. However, the risk retention ruleshave materially altered the economics of CMBS issuance, which washeavily reliant on a conduit ‘‘originate to distribute’’ model. Invest-ment banks were the sponsors of these conduits and retaining 5%exposure in every new transaction over its lifetime translates into asignificant drain on capital;

. significant derivatives legislation, with the European Commission’sproposed derivatives legislation potentially forcing European CREcompanies and funds to collateralise their interest rate swaps onfloating rate loans. In Europe, CRE loans are typically floating rate andswapped to fixed in order to hedge the risk of interest rates increasing.If borrowers were forced to cash collateralise these swaps, the cost ofborrowing on a floating rate basis would increase. Chatham Financialestimates that e64.9 billion of working capital could be required acrossEU Member States to comply with the legislation. If the proposedlegislation is passed, borrowers may prefer to use fixed rate loans or tohedge via out of the money caps. Fixed rate loans could be conducivefor issuing fixed rate CMBS, as is the norm in the US. However,

16 Basel III was introduced due to criticism of Basel II, based on risk-weighted assets, with therisk weighting given to certain assets based on ratings given by CRAs. The lower the creditrating, the greater the risk weighting given to the asset. Unfortunately, the Basel IIrequirements, which have been widely adopted, resulted in financial institutions across theglobe seeking out similar asset classes and similar highly-rated securities that would carrylower risk weighting, as under Basel II, banks were given the opportunity to define the riskweighting of each asset on their balance sheet using their internal risk models, under threemethodologies (standardised, foundation or advanced internal ratings based (IRB)), whichwere characterised by increasing levels of sophistication. The introduction of the Basel IIdiscipline often resulted in banks being able to reduce the risk parameters applied to theirassets and thus reduce the level of equity held against them, a move that has since beenwidely criticised. As a result, falls in the market value of these highly-rated securities havebeen felt throughout the financial markets and capital adequacy rules designed to improvethe stability of individual banks, have instead increased the level of systemic instability.

17 See further Ch.16 and the detailed discussion in Ch.17. The skin in the game provisions areattempting to combat the cyclicality and thus periodic crises of the CMBS markets byaligning the interests of the issuers and the investors. With a focus on minimising risk andstrengthening underwriting standards, originators and those that securitise will be requiredto retain some of the risk of the loans they originate or package as part of a CMBS.


15

European borrowers have traditionally rejected fixed rate loans due tothe prepayment penalties that are incurred if the property is sold andthe loan prepaid; changes to the IFRS accounting standards; andshifting and conservative rating agency treatment18;

. Solvency II, is an EU supervisory regime for insurers and reinsurers,introducing new capital requirements and tiering. Since 1 January2016 Solvency II has required insurance companies to hold capitalagainst the risk of loss in the market value of their assets. CMBS isclassified as a Type 2 securitisation, excluding it from favourabletreatment; even AAA rated tranches have a higher risk weighting thanCRE equity. This means that CMBS has become more expensive forinsurers relative to Type 1 securitisations and many other asset clas-ses. The requirement for risk weighting can be removed throughmatching adjustments where longer-dated real estate debt invest-ments are of a similar duration to long term insurance liabilities. Thefact that there is prepayment and extension risk for the repayment ofsecuritisations means that CMBS are unlikely to qualify as eligible formatching adjustment. On the other hand matching can be madepossible in relation to direct CRE lending. This incentivises insurancecompanies to invest directly in CRE rather than securitised debt. It isunlikely therefore that the growth of alternative sources of directlending in CRE will be replicated to the same extent in the CMBSmarket; and

. as a result of the Financial Conduct Authority’s (FCA) guidance on‘‘slotting’’, a method for assigning risk weights to lending exposures,greater scrutiny has been placed on the internal models used by banksin lending to specialised assets, including CRE. Slotting puts loans intofour categories depending on their LTV and capital weightings canrange from 50% to 250%. Banks have been expected to reduce theirexposure to balance-sheet intensive asset financing and commercialreal estate lending, which was previously one of their biggest on-balance-sheet activities. The British Bankers’ Association, in aresponse to the European Commission noted that ‘‘the changes to theSecuritisation framework and the imposition of the supervisory slot-ting approach for Specialised Lending (especially infrastructurelending) have lessened the attractiveness of these asset classes. Wethink that these rules overestimate the capital requirements leading tothe adverse impact upon these asset classes.’’19

1.5.1 Challenges to the wider European commercial mortgage market

Based on the reasons highlighted throughout this chapter, it remains thecase that, at the time of writing, CRE lending is less attractive for banks thanit was prior to 2007. CRE lending has transformed from purely property

18 See further Ch.14.19 See British Bankers’ Association response to DG FISMA consultation paper on the possible

impact of the CRR and CRD IV on bank financing of the economy and Ch.16.


16

focused to a relationship-driven business. Unlike in 2005–07, post GFC, thequality of the sponsor (ultimate equity owner of the property) of the non-recourse CRE loans and the prospects of ancillary business with the spon-sor, have become more important than ever. As a consequence, qualityprime sponsors stand the best chance of obtaining a loan secured by non-prime properties. Such transformation is based on a number of factors. Inthe Morgan Stanley Report, Morgan Stanley attributed the reduced appeal ofCRE lending to five factors (that whilst published in 2012, are still relevantat the time of writing):

(i) Financing is not easy and is expensive, especially for long-termtenures. The boom in CRE financing between 2004 and 2007 wasfostered by the availability of plentiful and cheap funding for thebanks, coupled with relatively low capital requirements. That is not tosay that all long-term lending is dead. Issuance of Pfandbriefe coveredbonds in Germany, for example, although more expensive than in thepast, still provides substantial financing for the industry.20 However,volumes are greatly reduced, and this will continue to constrain newbusiness;

(ii) capital is getting tighter, especially as under Basel III there is no dif-ferentiation of the risk associated with low LTV loans (the regimecurrently gives CRE loans secured on underlying assets as a higherrisk weighting than unsecured corporate bonds).21 This may mean thatbanks are no longer able to make a return on CRE lending that coversthe cost of equity, and indeed in some cases they may be loss making;

(iii) CRE relationships are less profitable than corporate client relation-ships. Ultimately, despite the fact that banks have over-extended theirbalance sheets to the real estate sector, this is still a marginal activityand one that does not relate to their core client base. Also, compared tocorporate lending, it provides lower ancillary revenues;

(iv) huge cyclicality makes the business less attractive. The peak-to-troughloan loss provisioning in CRE is significantly higher than that of anycorporate lending activity; and

20 See further Ch.2. and the German Lending Market section contained in Ch.18.21 This is subject to review under ‘‘Basel IV’’; in the first consultative document published by

the Basel Committee on Banking Supervision in 2014, real estate risk weights were to bebased on the LTV ratio and the debt-service coverage ratio rather than the previous 35% flatrate and under a second consultative paper published in December 2015, the Basel Com-mittee on Banking Supervision has proposed to use the loan-to-valuation (LTV) ratio as themain risk driver for risk weighting purposes, and to use a three-category classification (fromless to more risky) from general treatment for exposures secured by real estate whererepayment is not materially dependent on rent/sale of the property; a more conservativetreatment for exposures secured by real estate where repayment is materially dependent oncash flows (i.e. rent/sale) generated by the property; and a conservative, flat risk weight forspecialised lending real estate exposures defined as ‘‘land acquisition, development andconstruction’’. See Basel Committee on Banking Supervision ‘‘Second consultative docu-ment—Revisions to the Standardised Approach for credit risk’’ December 2015 (issued forcomment by 11 March 2016).


17

(v) there tends to be more pressure from governments and regulators tokeep financing corporates and SMEs in sectors that are more crucialfor the real economy.

Further, banks face other issues when trying to deleverage:

. lack of alternative financing is the single biggest issue banks encounterwhen trying to reduce their loan exposure. If borrowers cannot findalternative sources of funding, they cannot repay, unless they sell theunderlying assets;

. falling property prices mean that borrowers find it hard to sell andrepay, while quality of exposure declines and LTVs increase. Thisoften makes loan extensions and other forms of restructuring of CREloans that otherwise would be in breach of LTV covenants more likely;and

. swap transactions linked to loans may also prevent banks from sellingdown exposure more aggressively. As CRE companies prefer to takeloans at fixed rates and banks tend to want to lend at variable rates,banks usually sell an interest rate swap contract to the company thattakes the loan. These swap contracts are becoming an issue whenbanks try to offload the loans, as they may be forced to take losses onthe swap, especially if contracts have been put together when interestrates were higher.22

Further challenges to the commercial mortgage loan market include aproposal put forward in April 2016 by the Basel Committee that banks,rather than using the IRB model (see fn.23), be subject to the same standardrisk assessment model and recognise ‘‘slotting’’, already used by banks inthe UK (as referred to above). The institutions that could be most affectedby this latest Basel pronouncement are continental European banks thathave incurred significant expenditure in implementing IRB risk assessmentmodels to help them to maintain low costs of capital. If this regulation isimplemented, it could increase the capital requirements for European banksinterested in specialised income-producing loans, including CRE finance.

However, the fragility of the bank’s balance sheet during the GFC hashighlighted how the CRE market needs CMBS and its access to globalcapital markets. This means that CMBS certainly has a supporting role toplay and may eventually prove to be most competitive in financing yieldly,secondary properties that are not suited for on-balance sheet lending bybanks. In other words, CMBS could eventually become the equivalent of thehigh yield market for CRE finance with LTV potentially limited to 50–60%and required spreads in excess of 500bp.

22 See the Morgan Stanley Report, pp.22–26 and Ch.12.


18

Moreover, this chapter has shown that when discussing European CRE it isclear that globalisation cannot be ignored.23 The globalisation or inter-nationalisation of capital has played an integral role in the financial crisis,with both benefits and disadvantages. Such globalisation can provide foraccess to global markets, thus reducing financing costs and allowing forbusiness cycles to be smoothed, but it can also allow for the rapid trans-mission of economic shocks between economies. As discussed above,investors are able to purchase a wide variety of securities offered on variousinternational markets (by way of example, Swedish farmers had exposureto single parent families in Illinois), which has in turn allowed the impact ofthe sub-prime crisis in the US to spread around the world. Further, it alsoallows for regulatory arbitrage as financial institutions or investors transfertheir operations and investments to jurisdictions they perceive as favour-able. Regulatory arbitrage results in jurisdictions with inadequate regula-tion creating risks for other jurisdictions due to the interconnection ofeconomies and markets.

As regards real estate, the GFC highlighted that, whilst real estate remainsan essentially local illiquid asset, its financing is not and our real estatefinance markets and economies are inextricably linked and interdependentand it is very hard to dislocate the economic forces that they produce. Afterall, one of the most striking developments in the global debt and capitalmarkets over the last decade has been the powerful journey and meta-morphosis of CRE in creating a truly global market for CRE finance,investment and development, an asset class that had been famouslyregarded by institutional investors as illiquid and cumbersome. However, ifthe last decade will be remembered for this development, the followingdecade will be remembered for the creation of the post-GFC banking andfinancial regulatory landscape that affects real estate (and its financing,investment and development) as discussed further in Chapters 16, 17 and21.

The establishment of real estate as a separate asset class will not be reversedand it is undeniable that real estate will continue to be viewed as a popularasset class. Given that the GFC was as much due to a crisis of confidence asto any other factors, such re-emergence will, in a large part, be dictated bythe confidence in our financial architecture. Any developments or productsthe CRE market participants can provide to help restore market confidence,such as greater regulation and transparency, more sustainable lending,improved reporting standards, clarity over servicing standards and servicerresponsibilities24 and more standardised and clear documentation (parti-cularly uniformity surrounding intercreditor arrangements),25 that willhopefully reverse credit rationing and soften the impact of widespread de-

23 See A.V. Petersen, Real Estate Finance: Law Regulation & Practice, (London: LexisNexis, 20081st edition and 2014 2nd edition).

24 See further Ch.21.25 See Chs 5, 6 and 7.


19

leveraging, as well as remove or reduce risk to investing in real estate, canonly be a good thing. However, the overriding aim must be to strike abalance between market reform (through all of the above) and efficientmarkets. It is our financial architecture. Markets are essential to humandevelopment through economic advancement and human well-being andshould not be impeded or innovation suffocated such that they cannotfunction. Nor should markets be allowed to operate with unintendedconsequences which sow the seeds for future crises. After all, this Chapterhas highlighted that we have been down this road before and whilst thiscrisis remains structural rather than cyclical, the desire to reform must beaccompanied by caution. The remaining Chapters in this book will examinethe markets in this light, to determine whether the funding of CRE throughcommercial mortgage loans and CMBS can continue to adapt and evolve ona journey based on alchemy and financial innovation.


20

Chapter 5

Leverage and the use of Subordinate Debt

Andrew V. Petersen,

Partner and Practice Area Leader–Finance, K&L Gates LLP

5.1 Introduction

As highlighted throughout this book, a significant development in thecapital markets over the last two decades has been the arrival of real estatedebt on the global stage as an asset class in its own right. Based on itsincreasing popularity, the financing and investment of CRE flourished inthe market in the period up to 2007, as a result of a highly competitive CRElending environment, yield compression and the evolution of attractivecapital market exits.1

During this period, lenders were forced to be more innovative in struc-turing CRE loans to keep pace with (i) investors’ vociferous appetite forCRE assets, (ii) the escalating need for leverage, and (iii) their competitors.As a result CRE quickly became seen not only as a hard asset but also afinancial one. Consequently, lenders were forced to provide much higheramounts of leverage than they traditionally did, or may have been com-fortable with. However, with the capital markets providing an exit, bankswere able to package this additional leverage in a way that appealed toinvestors across the risk-tolerance spectrum and accommodated a mortgageborrower’s desire, to constantly maximise leverage.

Moreover, CRE borrowers’ demands for even more flexibility and leverageled to lenders undertaking a constant balancing exercise, between origina-tion volume and their return on their product, without compromising anysecuritisation or syndication exit, or, in the environment that exists at thetime of writing, a club deal exit.2 This led to a marketplace where sub-ordinate debt structures became commonplace.

In the US, where subordinate debt structures first emerged, originatinglenders discovered that dividing or splitting a whole loan into multipletranches enabled them to create a variety of debt instruments which wouldappeal to a broad array of investors, while meeting the demands of theirmortgage borrowers for greater leverage and flexibility. For example, on a

1 See further Ch.1.2 See further Ch.3.

107

highly-leveraged property, the related financing was typically structured soas to produce an investment grade portion of the debt that was included ina CMBS, with the remaining portion of the financing split into one or moresubordinated tranches, often tailored to meet the requirements of theanticipated purchaser. Thus, for example, a certain investor’s risk andreturn preference might cause such an investor to prefer a slice of the debtthat represented 60–70% of the overall leverage of the financing; with othermore opportunistic investors with more aggressive risk and return toler-ances preferring more deeply subordinated, higher risk, higher-yieldingtranches of the financing, at 70% plus. Methods adopted to achieve thisbalance or alignment of rights was achieved through the introduction ofsubordinated debt (junior or mezzanine) and the bifurcating of the com-mercial mortgage whole loan.

This development was not a new development in ‘‘traditional’’ (i.e. non-securitised or non-capital markets) global CRE finance transactions, withcommercial mortgage loans with related bifurcated subordinate debtappearing frequently in the market. Gradually, such structures found theirway into the CMBS market and 2003 witnessed one of the first Europeanuses of an AB loan structure included in a CMBS deal, where the under-lying whole loan was split into a separate participation in the underlyingloan, with only the senior tranche being securitised and the junior trancheswere held outside the CMBS.

Following this, between 2003 and 2007, the CMBS lending market witnesseda proliferation of highly complex modelled subordinate debt structuresincorporating a concept of bifurcated or trifurcated real estate loans, com-prising of A-1 or A-2, B, C or even D tranches, senior-subordinate tranchesand mezzanine or junior debt. As discussed below and in the followingChapter, this practice generated highly flexible structures that built uponthe emergence of CMBS as a product of innovation.3 A product that allowedthe subordinate debt to be tailored to comply with the demand in themarket, the underlying borrowing group structure and the available lenders(and their legal and regulatory requirements).

Whilst the CRE financing market continues to operate at a vastly reducedlevel to the boom years of 2000 to 2007, at the time of writing, an improvingand growing funding market is emerging. This means that, in an increas-ingly competitive market, senior lenders are able to pick and choose thedeals and the pricing on such deals, with an increasing amount of seniordebt becoming available for good secondary assets with secured income, aswell as higher-priced defensive subordinated or stressed/distressed loan-on-loan financing. This is true, even of certain senior lenders that writecheques for substantial senior whole loans that internally will tranche orsyndicate the loan to a mezzanine provider or fund set up or controlled by

3 Andrew V. Petersen (ed.) Commercial Mortgage-Backed Securitisation: Developments in theEuropean Market, 1st edn (London: Sweet & Maxwell, 2006), Ch.1. and 2nd edn (2012).


108

such senior lender. Thus, it has become a rare exception for real estate loansnot to be structured with some form of multiple separate subordinate debt.Such structures apply to both single and multi-borrower transactions.

In this Chapter, the debt underlying such structures (mezzanine or tranchedjunior) will be referred to as subordinate debt and generally take one of thefollowing two forms:

. a mezzanine loan interest which is documented pursuant to a separateloan and secured by a separate (or shared) security package rankingbehind the security interests securing the senior or whole loan, or incertain cases a separate security pledge over the equity in the bor-rower (mezzanine debt);

. a B Loan within an AB loan structure, where the single whole loan istranched into senior and subordinated tranches which are secured bya single security package (AB debt).

This Chapter will examine:

. the emergence of subordinate structures including the key principlesand pricing of such structures;

. the common key principles of intercreditor terms surrounding sub-ordinate structures4;

. the economics and business case for utilising mezzanine debt and/orAB debt;

. the emergence of recent developments surrounding discounted pur-chase options (DPO).

5.2 The key principles of subordinate structures

It is important to understand the economics behind subordinate debtstructures. Therefore the key principles that underpin such structures mustbe examined, while noting that there can be variations on all of theseprinciples, as no two deals are the same and that each deal will be facedwith unique characteristics based on asset type, obligor or borrower groupstructure (including any legal and regulatory and other restrictionsregarding granting of security or historic tax liabilities).

5.2.1 Mezzanine debt

A typical mezzanine secured credit facility (the mezzanine facility) willcomprise a term facility that is subordinate to, but coterminous with asenior loan facility. Often the mezzanine facility may increase by any

4 Note that the key commercial terms and provisions of an intercreditor agreement will beconsidered in detail in the following Chapter and the key legal terms and provisions will beconsidered in Ch.7.


109

payment in kind (PIK) or other amounts accrued. Typical leverage will bean aggregate of the senior facility and mezzanine facility capped at a certainpercentage (say 80%) of value of the underlying real estate portfolio. Thesenior facility will fund a lower percentage of the value, typically in therange of 60–70% LTV.

5.2.2 Mezzanine debt pricing

At the time of writing, there is no ‘‘typical’’ pricing of mezzanine debt.Pricing will be dependent on a number of factors, including the size andquality of the deal, the nature of the asset, the number and type of lenderschasing the deal, the economic power of the underlying sponsor and thejurisdiction of the underlying assets. For deals occurring at the time ofwriting, mezzanine pricing will be in a range from percentages in the highsingle digits to mid-teens per annum (all-in coupon) of which an elementwill often be structured to be payable in cash (cash pay interest) and anelement may be PIK-ed.

Mezzanine debt may be further structured where the mezzanine lenderreceives a percentage of excess profits once the sponsor achieves a certainlevel of internal rate of return (IRR) known as a profit participation. Theprofit participation will be in addition to any fees and interest payable onthe deal. Typically, a mezzanine lender will want to be compensated for itsdebt being repaid prior to the maturity date. Although, a voluntary pre-payment will be permitted at any time after the first year of the termmezzanine facility, prepayment fees will be payable to the mezzanine len-der to protect a certain fixed level of return (say 1.35 times equity multiple)on the mezzanine debt. For example, if the mezzanine facility is prepaidand the mezzanine lender has not received a minimum of 1.35 times on theoriginal principal amount of the mezzanine facility, then the mezzanineborrower will compensate the mezzanine lender for the difference betweenthe amount actually received by the mezzanine lender and an amount equalto 1.35 times of the original principal amount. Alternatively, the mezzaninelender may agree an exit fee equal to a specific percentage of an amountrepaid or prepaid.

Key terms of a senior loan facility sitting above a mezzanine facility mayinclude: loan to value covenants, with a hard event of default triggered ifLTV or ICR values raise above a certain percentage; a cash sweep triggeredif LTV values are above a certain percentage, funded by equity or excesscash, and upon such sweep being activated monies being swept to repay thesenior loan or placed in reserve to be retained for future cash flowshortages. A cash sweep will often continue until the LTV or ICR valuesreduce below a certain percentage on two consecutive interest paymentdates (IPD).


110

5.2.3 Borrower PIK election period

Typically, on any IPD where there is a cash trap event caused by triggers inthe senior facility which has the effect of stopping cash pay interest to themezzanine facility (The PIK election does not apply to hard events ofdefault), the borrower may make a PIK election where the total coupon isaccrued or rolled and forms part of the mezzanine facility balance until theoccurred amount is paid down by the borrower. Typically, the borrowerwill be limited to a maximum of two PIK elections during the term of themezzanine loan and will not be able to use its PIK election if this wouldcause a breach of the mezzanine facility hard default covenants. Followingany PIK election quarter where the borrower has no remaining PIK elec-tions, a mezzanine facility event of default will be triggered if the mezza-nine facility is not cash paid on any remaining IPD (and the cash escrowreleased to the mezzanine lender).

5.2.4 Typical mezzanine security package

In a senior/mezzanine funding structure, the senior loan will typically beadvanced to the property owning company (the Senior Borrower) while themezzanine loan will typically be advanced two levels, above the SeniorBorrower, to the shareholder of the shareholder of the Senior Borrower (theMezzanine Borrower). The Senior Borrower’s shareholder (the Senior Par-ent) provides ‘‘insulation’’ to the senior lenders that mitigates the risk of themezzanine lenders bringing claims against the senior lenders’ own obligors.

The loan advanced to the Mezzanine Borrower will be on-lent to the SeniorParent and in turn on-lent to the Senior Borrower, in each case by way of anunsecured ‘pay as you can’ subordinated loan that will be contractuallysubordinated behind the senior loan and the mezzanine loan.

In a very simplistic case, the rental income stream from the Senior Borrowerwill then be utilised on a periodic basis:

. first to make payment of all fees, costs, expenses, interest and principalrepayments due on the senior loan;

. secondly, provided there is no continuing default on the senior loan,up streamed to the Mezzanine Borrower to make payment of all fees,costs, expenses, interest and principal repayments due on the mez-zanine loan.

For so long as the senior loan is in default, typically no payments areallowed to be made in respect of the mezzanine loan and all amountsavailable for distribution will be applied in repayment of the senior loan (ortrapped in a senior controlled account) until it is repaid in full.

Subject to the differences in the overall structures and underlying borrowergroups, security for a typical mezzanine facility will consist of the same


111

typical security package expected for a senior facility, albeit on a sub-ordinated basis, which shall include the following:

Shared with the senior facility (on a subordinated basis) or separate secondranking, each to the extent applicable:

. legal charges over the properties;

. fixed and floating security over all the assets of the borrower(s),including without limitation all bank accounts, material contracts(such as managing agent contracts), insurance (including being co-insured), the hedging arrangements related to the mezzanine facilityand all shareholder and other intra-group loan balances;

. deed of subordination between the mezzanine lenders and anyshareholder loans or equity confirming neither interest nor repaymentof any shareholder’s loans or equity permitted until mezzanine facilityfully repaid;

. a duty of care letter from the managing agents, if any; and

. any other security as required under the senior facility.

This is typically in the form of common or shared security whereby thesenior security agent holds the security on trust for the benefit of the seniorand the mezzanine finance parties, but sometimes by way of separate sec-ond ranking security. In both scenarios, the mezzanine finance parties willnot be able to enforce such security interests until the senior finance partieshave been repaid or enforced their security. In addition, the mezzaninefinance parties will also take a first ranking charge over the shares in theMezzanine Borrower and in the Senior Parent and over any intra-grouploans made to the Mezzanine Borrower and to the Senior Parent. Thecommon security is held for the benefit of all lenders, whereas the mezza-nine security is granted solely for the benefit of the mezzanine financeparties. The mezzanine finance parties are typically free to enforce the firstranking mezzanine security following an event of default on the mezzanineloan for the purposes of taking control of the equity in the MezzanineBorrower or the Senior Parent, subject to any restrictions in the intercreditoragreement.

In addition, based on potential deal structure and requirements of themezzanine lender, a first ranking pledge of shares in the mezzanine bor-rower (or any other appropriate entity depending on the final structure ofthe transaction) representing control over the entirety of the properties. It isoften requested that, in an acknowledgment of the credit support themezzanine facility is providing and the first loss position it is in, suchsecurity is separate and not part of the security package for the seniorfacility and without any turnover obligation to the senior lenders uponexercise/enforcement or exercise of voting rights attaching to such shares.


112

Given the subordinated nature of the mezzanine loan, a senior default willalways cross default and cause a default of the mezzanine loan. However, amezzanine default should not result in a default of the senior loan.

5.2.5 Valuation

Often, the mezzanine lender shall, at the mezzanine borrower’s expense,have the right once per year to call for a valuation in accordance with theRICS ‘‘red book’’ or at any time if it reasonably believes there may be adefault or at any time if an event of default is outstanding. Typically, if themezzanine lender uses this right (in addition to the standard annualvaluation provided to the lenders at the borrower(s) expense) that themezzanine lender will bear the costs of such additional valuation to theextent that this valuation does not result in a cash sweep or an event ofdefault.

5.2.6 Documentation

The mezzanine facility will normally be documented by a facility agreementand related security documentation which are normally based on the LoanMarket Association (LMA) documentation5 used for the senior facility(often using the same form of senior facility after it has been negotiated withthe senior borrower/sponsor), this agreement will set out (inter alia) theconditions precedent to drawing, representations and warranties, under-takings, events of default triggers, borrowing costs, pro-rata sharing, set-off,and other provisions usual for such transactions.

The mezzanine facility agreement outlines the relationship between themezzanine borrower and mezzanine lenders, and an intercreditor agree-ment6 outlines the relationship between lenders.

The 2012 Draft Guidelines and the LMA ICAs contemplate a transactionstructure where two loans are advanced to finance CRE assets: a senior loanto the property owning entity (the propco) and a mezzanine loan to amezzanine borrower (who is the sole shareholder of the parent of thepropco). The effect of this structure is to structurally subordinate the

5 On April 16, 2012, in an attempt to aid transparency and liquidity in the market, the LoanMarket Association launched its recommended form of single currency term facilityagreement for use in real estate multi-property investment transactions. The new documenthas assisted standardise the approach taken to real estate specific issues by reducing thetime spent negotiating boiler-plate type clauses.

6 On 10 June 2014 the Loan Market Association published a form structural subordinationintercreditor agreement and in August 2016 the LMA produced a contractual subordinationintercreditor agreement (the LMA ICAs) providing boiler plate and a structural framework.Whether an intercreditor agreement is based on the LMA ICAs or another form, commercialarrangements between lenders have been subject to on-going discussion and developmentand so, to supplement the 2012 Draft Guidelines, CREFC has in 2016 produced commentaryon these commercial developments (the Intercreditor Agreements—commentary on recentcommercial developments.


113

mezzanine loan to the senior loan. The intercreditor agreement, includes,amongst other provisions, the right of the mezzanine lender to freelyenforce its security without triggering a change of control default or man-datory prepayment obligation under the senior facility. The right of themezzanine lender to cure a senior event of default and the right to purchasethe senior facility if accelerated may also be included. In addition to theforegoing, the senior lender will agree not to change any payment date ormaturity, increase or vary any fee or interest payable, increase or varyprincipal or require amortisation or prepayment, or amend events ofdefault without the prior written consent of the mezzanine lender. Often, itis required that the senior lender consult with the mezzanine lender prior toenforcing its security.

The documentation will also contain conditions precedent, undertakingsand covenants, representations and warranties, customary for the finan-cings the subject of the deal and in a form and substance satisfactory to theparties and at a minimum mirroring the conditions precedent under thesenior facility. Both the commercial and legal terms of an intercreditor willbe dealt with in the following two Chapters.

5.2.7 The typical features of AB debt structures

There are certain common features existing within AB debt structures.7 Onesuch feature is that, although B lenders lack the right to enforce the mort-gage loan security they do typically benefit from certain rights followingmonetary events of default on mortgage loans, in a recognition that they are(as described above for mezzanine debt structures) in the first loss position.

Such rights are not usually available to junior first loss piece holders in aCMBS, known as the ‘‘B piece holders’’. The B piece holders in a CMBS holdthe most junior note interest in a securitised pool of CMBS loans. They holdthe ‘‘last pay’’ ‘‘first loss’’ note which do not represent individual loans andhave no direct relationship with the mortgage borrower, and should not beconfused with the B lenders or B loan holders.

B lenders are not obliged to exercise these rights, which vary from deal todeal and ultimately depend on the sophistication and the needs of the

7 AB Structures were very popular in Europe from 2003 to 2007. See further A.V. Petersen,Commercial Mortgage-Backed Securitisation: Developments in the European Market, 1st edn(London: Sweet & Maxwell, 2006), Ch.8. As described herein, their popularity has lessenedwith the demise of the availability of financiers (and the absence of a fully functioningEuropean CMBS market) that are prepared to arrange or originate a whole loan that willcover the whole of the required debt, although they are still used by certain senior lendersthat originate a whole loan and internally tranche such loan into an AB structure and are, atthe time of writing, emerging in the marketplace, in an attempt to be economically the sameas a senior/mezzanine structure, necessitating the LMA launching their contractual sub-ordination agreement in August 2016 and the CREFC-Europe launching commentary onsuch intercreditors in 2016.


114

parties. In theory, B lenders would generally only exercise their rights if theexpected recoveries from the mortgage loan would thereby be enhanced.The exercise of cure and repurchase rights (which usually include the Blender’s right to purchase the A loan as a means of avoiding enforcementproceedings by the A lender following a mortgage loan payment default bymaking whole a mortgage loan payment) has implications for the A loanand thereby the rated bonds and in such cases, the structure of the inter-creditor and servicing agreements are extremely important and requiredetailed analysis and consideration.

5.2.8 The attraction of AB structures

AB structures were very popular during the growth of the European CMBSmarket in the decade up to 2007. From the perspective of the most juniorinvestor in a CMBS, as payments to the B loan can be subordinated to the Aloan in an AB structure, CMBS transactions with AB loans are preferable toCMBS transactions without such a structure. This is because, depending onthe transaction structure, as we have seen above, payments to the B lendermay be cut off entirely following an underlying mortgage loan monetaryevent of default until the A loan has been redeemed in full.

Thus, by creating a B loan that is held outside the CMBS, loss severity canbe viewed as having been reduced as, following a loan monetary event ofdefault, the A lender benefits from the subordination of payments to the Bloan by having the ability to take control over the whole loan and instigateenforcement proceedings before a shortfall has occurred on the A loan, andtherefore the rated bonds. This allocates the risks associated with incor-porating the additional debt efficiently throughout the market and is pre-ferable to a standard CMBS, in which senior noteholders gain control onlyafter realised losses have eroded the value of the junior CMBS notes. Fur-thermore, this results in an improvement of the subordination levels of therated securities versus the subordination levels if the entire loan wasincluded in the CMBS.

However, for multi-loan CMBS transactions, which may pool togethervarious A loans, the additional credit support provided by the sub-ordinated B loans is specific to the individual A loans to which the B loanrelates and is therefore not provided to the entire transaction, usuallyresulting in higher credit enhancement being expected for the lowest-ratedlevel of securitised notes. If losses incurred on any one loan exceed theamount of the B loan, the excess will be allocated to the lowest-rated class ofnotes.

It is important to note, however, that although a higher percentage of therated securities are considered investment grade in a pool that is made upof A loans, the investment-grade debt as a percentage of the first-mortgagedebt (the first-mortgage debt equalling the combined total of all A and Bloans) is not higher. In fact, in most cases the investment-grade debt as a


115

percentage of the first-mortgage debt would be lower than if the entire loanwere deposited into the CMBS. This is due to the weaker form of creditsupport provided by the B loans that are not cross collateralised, comparedto subordinate bonds, which are cross collateralised. For instance, in a poolmade up of A loans, if a loan incurs losses, upon the erosion of the B loans,losses would continue upward into the rated securities and not to the otherB loans held outside of the CMBS.

At the time of publication of the 2012 Draft Guidelines it was felt that wholeloan structures would not typically find market favour. However, at thetime of writing it has become apparent that certain lenders and equitysponsors have a preference to utilise whole loan structures when con-structing debt finance packages. This is because whole loan structures canhave certain advantages over structural subordination models—both on theborrower and on the lender sides.

From a prospective B loan purchaser’s perspective there are several benefitsto an AB structure. First, the B loan is secured by a preferred form ofsecurity, a first mortgage. Also, for many of the institutional B loan pur-chasers, risk-based capital reserve requirements are less onerous for B loansthan that of subordinate bonds. Having to reserve less capital against Bloans effectively increases their overall net yield. When contrasted withinvesting in subordinate bonds, the primary benefit of the B loan is theability to isolate risk to one asset. Unlike a subordinate bond where lossescan be incurred from any one asset in a pool, the loss potential of a B loan islimited to the asset(s) serving as security to the B loan. This makes it easierthan in a whole loan CMBS, where the originator, when placing a pooledbottom class of risk, has to try and sell this risk to an investor willing to takethe first loss risk on all of the loans in the pool. As a result, risk is effectivelydealt with much more discretely and the risk assessment of potential sub-ordinate debt investors is also much more efficient since the due diligenceprocess of evaluating one asset (the B loan) is considerably easier thanevaluation of a pool of subordinate bonds. This is especially so in theEuropean market where there is a multitude of loans and variety of assetclasses within pools. Another benefit, as discussed above, is the ability toeither purchase or cure upon an event of default. While this feature may notalways be a viable option, it may be a potential exit strategy. Further, on thelender side there is additional flexibility offered to arrangers in being able tooriginate a whole loan and determine the sizing and pricing of thetranching at a later stage. Quicker execution may therefore be available if awhole loan structure is used.

5.2.9 Why utilise subordinated structures?

Given the additional complexity of subordinate structures, the naturalquestion to ask is why incorporate this type of instrument into real estatedebt transaction? It would be much simpler to just have one lender and one


116

loan. But from a business standpoint, the use of subordinate debt isimportant to a number of stakeholders in a real estate transaction.

From the sponsor’s point of view, mezzanine debt typically carries a returnthat is lower than the return required by the common equity and allows thesponsor to invest less cash in a transaction, whether it is for an acquisition,or, refinance. This additional leverage can be accretive to the deal andusually helps to enhance the deal’s internal rate of return (IRR).

From the senior lender’s point of view, since mezzanine debt is structurallysubordinate to the first mortgage, it provides credit enhancement and asignificant capital buffer against collateral value deterioration. Moreover, byincorporating subordinate, the senior lender is able to reduce the amount ofrisk they would otherwise have to hold on their balance sheet.

From the mezzanine lender’s perspective, subordinate debt produces ahigher yield than senior debt, because there is more risk involved on arelative basis, but is still collateralised.

5.3 Key principles of a senior/mezzanine intercreditoragreement

As discussed above, in a subordinate structure, the legal relationshipbetween the lenders is delineated in an intercreditor agreement (inter-creditor), which both grants and limits certain important rights (which mayhave an impact on the senior lender), to the subordinate lender. Whilst thenext two Chapters will examine the key commercial and legal terms andprovisions of an intercreditor agreement in detail, this Chapter will brieflyset out certain key structural features.

The list below is not intended to be exhaustive and there can be variationson all of these principles as no two deals are the same and each deal will befaced with unique characteristics based on asset type, obligor or borrowergroup structure (including any legal and regulatory and other restrictionsregarding granting of security or historic tax liabilities). The principlesbelow represent the key terms and principles for an intercreditor governingthe relationship between a senior loan (senior loan) made by a senior lender(the senior creditor) and a mezzanine loan (the mezzanine loan) made by amezzanine lender (the mezzanine creditor). In such a hypothetical case, theprincipal terms that may be included in the intercreditor are as follows:

5.3.1 Acceleration/enforcement

The senior lenders will have the right, subject to any applicable cure rightsthe mezzanine lenders may have and subject to certain standstill periodsrelating to the mezzanine lenders’ rights to acquire the equity in the Mez-


117

zanine Borrower and their rights to acquire the senior debt from the seniorlenders, to take any enforcement action in respect of the senior loanincluding enforcement of its security (whether common security or standalone first ranking security) once the senior loan is subject to a continuingevent of default. In recognition of the subordinated nature of the mezzanineloan, the mezzanine lenders will have no right to enforce their interests inthe common security or their standalone second ranking security until thesenior loan has been repaid in full or if the senior lenders otherwise consentor, following a fairly lengthy period of time (and often subject to a raft ofother conditions) after the senior lenders have failed to take enforcementaction following the occurrence of a senior event of default. In the event thatthe mezzanine lenders do instruct the enforcement of common security thisdoes not afford the mezzanine lenders with the right to control or directhow the security is enforced and the common security agent would still acton the instructions of the senior creditors. Any proceeds of enforcementwould be applied first to discharge the senior debt in full and, once dis-charged, be applied in and towards the discharge of the mezzanine debt.The mezzanine creditor may require the mezzanine loan facility agent/security trustee to exercise voting rights under the first-ranking sharepledge over the mezzanine loan borrower (or if the mezzanine loan bor-rower is the same as the senior loan borrower, over the borrower’s parentcompany) if an event of default (other than a material default (as definedbelow)) is outstanding.

The senior creditor shall not require nor instruct the senior loan facilityagent/security trustee to take any enforcement action under any securityunless it has first consulted with the mezzanine creditor or if the period toexercise any mezzanine lender cure rights have expired.

It is common practice in senior-mezzanine lending structures which includestructural subordination, for the mezzanine lenders to have security overthe shares in the Mezzanine Borrower. Upon an event of default under themezzanine loan agreement (which would not in itself constitute an event ofdefault under the senior loan agreement), the mezzanine lenders would beentitled to enforce the share security and acquire all (but not some) of theshares in the Mezzanine Borrower, effectively to step into the equity of theMezzanine Borrower and, indirectly, the Senior Parent and, in turn, theSenior Borrower.

Exercising these acquisition rights is ordinarily subject to a number ofconditions, including curing any remediable senior events of default thatare then continuing.

5.3.2 Permitted payments

The intercreditor will contain waterfalls setting out the priority of paymentsprior to and following the occurrence of a material default. Prior to amaterial default (as defined below), interest and principal payments


118

(including any prepayment fees) made by the borrower are to be applied inaccordance with the loan agreement.

Upon the occurrence and continuance of a material senior default, cash willbe distributed sequentially according to a post-default waterfall resulting ina cessation of cash to the mezzanine creditor and diversion of cashflow tothe senior creditor. This will be dealt with in further detail in the followingChapter.

5.3.3 Limit on senior loan

Often any senior loan headroom concept in an intercreditor will be cappedat 5–10% to deal with the provision of property protection loans. Thismeans that any increase in the amount of senior loan above any permittedheadroom will rank behind the mezzanine loan (excluding any increase inamount of mezzanine loan).

5.3.4 Cure rights

Upon the occurrence of an event of default (other than certain insolvencyrelated events of default) which is remediable, the mezzanine creditor mayremedy that default within grace periods between certain fixed periods (say15 business days in relation to a payment default and 20 business days inrelation to other defaults)—each period will be negotiated depending on thecircumstances of the deal.

It will often be requested that cure periods for defaults other than paymentdefaults should be unlimited for so long as the mezzanine creditor is dili-gently pursuing a cure, again to be negotiated on a case by case basis.Further, the mezzanine creditor may request that it may take such action toremedy as it considers desirable in the circumstances. For remedy of apayment default or financial covenant default, certain actions may beexpressly permitted including:

. prepaying the senior loan (excluding default interest and prepaymentfees);

. paying the amount of the shortfall;

. placing a deposit on behalf of the senior loan facility agent/securitytrustee into a cure loan deposit account in an amount equal to theadditional amount of net rental income which would have beenrequired to have been received by the obligor to have complied withthe relevant financial covenant; or

. obtaining and delivering to the senior loan facility agent/securitytrustee an unconditional and irrevocable standby letter of creditpayable on demand and in an amount equal to the additional amountof net rental income which would have been required to have beenreceived by the obligor to have complied with the relevant financialcovenant.


119

The mezzanine lenders will be limited in the number of times they canexercise their cure rights. Typically, an intercreditor will provide a limit onthe number of times that a payment default can be cured, so that the cureright may not be exercised more than a fixed number of times, say twiceconsecutively in any one 12-month period and no more than four to sixtimes during the term of the facility. It will further be requested that thereshall be no limit on the number of times a payment default may be curedwhere such default is continuing for a 90-day period or more and that therewill be no limit on curing other defaults (to the extent the borrower’s curerights are unlimited). An intercreditor may also specify the numbers ofcures are limited to one more than the Senior Borrower has under the seniorfacility agreement. Each time the Senior Borrower exercises a cure right itreduces the number of cures available to the mezzanine lenders and viceversa.

Often it will be provided that any repayment of cure payments made by themezzanine creditor in respect of cure rights will rank behind the senior loanbut ahead of the mezzanine loan. Further, during the exercise of cure rights(and the applicable grace periods for making cures), the senior creditor shallbe prohibited from taking enforcement action in respect of any relevantevent of default.

For so long as the mezzanine lenders are exercising their cure rights withinthe permitted timeframe the senior lenders will be prohibited from takingany enforcement action with respect to the event of default which is thesubject of the cure rights. However, if another senior event of default occurswhich the mezzanine lenders are either not entitled to cure or are notexercising their right to cure, then the senior lenders will be entitled to takeenforcement action in respect of that event of default.

5.3.5 Purchase/buy-out rights

In recognition that it is best to have an incentivised mezzanine lender in thedeal compared to a dis-incentivised sponsor or borrower, the intercreditorwill typically provide that at any time after the occurrence of any event ofdefault under the senior loan or any enforcement action, the mezzaninecreditor may elect to acquire the senior loan at par plus accrued interest,any swap breakage costs and funding break costs incurred by the seniorcreditor as a result of the transfer but excluding prepayment fees anddefault interest or at a price as otherwise agreed between the lenders.

5.3.6 Amendment rights

In further recognition of the interconnection between the senior loan andthe mezzanine loan, an intercreditor will often provide that certain materialeconomic provisions of the senior loan finance documents must not beamended or waived without the prior consent of the mezzanine creditor.These are dealt with in detail in the following two Chapters.


120

5.3.7 Consultation

An intercreditor may provide that a senior creditor and a senior loan facilityagent/security trustee will notify and consult with the mezzanine creditor(without the need for their approval save for enforcement action) beforetaking any formal step to exercise any remedy against the borrower ortaking any enforcement action (which shall require the approval of themezzanine creditor), save where the senior creditor reasonably determinesthat immediate enforcement action is necessary in order to prevent thematerial diminution to the value, use or operation of the security or amaterial adverse effect to the interests of the senior creditor under thesenior loan finance documents—the so-called senior creditor override—aprovision that acknowledges the position of the senior loan and its securityand the position of the senior creditor in maintaining control of its securityand its recovery on the senior loan.

5.3.8 Developments involving DPOs

A major effect that emerged in 2007 as lenders/investors withdrew creditwas the ever-decreasing pool of investors buying CMBS. With the origi-nation/distribution model that CMBS shops had relied on effectivelyclosing down, many originators and holders of debt, faced with the pro-spect of having to sell the logjam or overhang of assets remaining on theirbooks that were destined for a CMBS execution, turned to borrower orsponsor affiliates to buy some of their own debt. The lack of liquidity in themarket drove pricing and values down, thus borrowers and sponsors sawsense for them to use available cash to purchase perfectly good debt (intheir eyes).

Thus the DPO market was born and with the market evolving very rapidlyand investors in short supply and senior bankers (and their new stateshareholders) demanding the mortgage-laden balance sheets of the banksbe cleared out before the prospect of any true market in CRE lendingcommencing once again.

A DPO purchase is not without its challenges. In most cases, CMBS docu-ments do not provide for such a transfer without the involvement andagreement of the CMBS parties, being the issuer, noteholders and the Blender. Often CMBS servicing agreements8 will state that except as con-templated by the issuer deed of charge and the intercreditor agreement, aservicer will not be permitted to dispose of any loan or any B piece. Inaddition, the usual forms of power of attorney granted under a CMBS dealnormally expressly prohibit a servicer from selling the debt to the borrower.Further, typically an intercreditor will not provide for the sale of the debt orB piece and the issuer deed of charge often states that a sale of any of theissuer’s loans is not permitted unless the note trustee is enforcing its

8 See further Ch.11.


121

security or its sale back to the originator under the original mortgage loansale agreement. Moreover, as far as an issuer is concerned, it is usuallyrestricted from disposing of its assets unless it has the consent of the notetrustee. The note trustee would usually not give its consent unless it gets theconsent of the most senior class of noteholders.9 Moreover, the intercreditorwill often contain an absolute restriction on the B lender selling its loan tothe borrower or an affiliate of a borrower. Therefore, the B lender wouldneed the consent of the issuer and the facility agent to undertake such a sale.

Notwithstanding these challenges and any prohibitions in the intercreditor,the DPO market still, at the time of writing, remains popular and consent toa transfer of the B loan to a borrower/sponsor affiliate may be sought on thebasis that the rights of any B lender (that is also a sponsor or borroweraffiliate) should be turned off and should not be exercisable whilst the Blender remains a borrower or sponsor affiliate. This has the effect that,immediately following any such transfer, the B lender will not be able toexercise, have exercised on its behalf (other than by a servicer or a specialservicer in accordance with the terms of the servicing agreement) or haveaccruing to it any cure, enforcement, consultation, approval, appointmentand/or control rights (together the ‘‘Rights’’) otherwise available to it underthe terms of the underlying credit agreement, the intercreditor and/or theservicing agreement.

Typically, following a DPO to a borrower or its affiliate, the Rights shouldbe reinstated (1) for so long as the B lender (A) does not control or manage(in each case directly or indirectly) the management or voting rights in themortgage borrower or an affiliate of the mortgage borrower; (B) is notcontrolled or managed (in each case directly or indirectly) by a mortgageborrower or an affiliate of the mortgage borrower; (C) is not party to anyarrangements (the ‘‘Arrangements’’) with any other entity pursuant towhich the mortgage borrower or any of its affiliates would have anyindirect control of whatsoever nature in relation to any of the rights; and,for the avoidance of doubt, (D) is not a mortgage borrower or an affiliate ofthe mortgage borrower, in each case being confirmed to the reasonablesatisfaction of the security agent; or (2) with respect to the whole or any partof the transferred B loans, following a subsequent transfer or assignment ofsuch participation by the B lender, as discussed below.

Moreover, the transfer should further provide that each of the servicer andthe special servicer will be required to notify the B lender (or any of itsdesignees) with respect to material actions (as determined by the servicerand/or special servicer acting reasonably) to be taken with respect to thewhole loan provided that: (A) neither the servicer or, as the case may be, thespecial servicer will be required to disclose any information to the B lenderthat, in the discretion of the servicer or the special servicer (acting reason-ably), as applicable, will compromise the position of the other lenders in the

9 See further Ch.13 where the role of the trustee is further discussed.


122

deal or reveal any strategy of the other lenders that could compromise theposition of the other lenders with respect to the whole loan; (B) no suchnotification will be required where immediate action is required to be takenin accordance with the Servicing Standard10; and, for the avoidance ofdoubt, (C) no such rights shall oblige the servicer and/or special servicer totake into account any advice, direction or representation made by the Blender in connection with such notification.

Furthermore, the B lender should agree that, prior to any subsequentassignment or transfer of whole or any part of any transferred B loan beingeffective (along with the ability to exercise all or any corresponding rights),(i) the B lender either confirms or procures confirmation to a security agentthat the subsequent assignee/B lender is a ‘‘qualifying lender’’; and (ii) theconditions set out in each of the underlying credit agreement and theIntercreditor agreement must be otherwise complied with.

5.4 Conclusion

This Chapter has highlighted the purposes, general key features, risks, andbenefits provided by typical subordinate structures. Prior to 2007, manyregarded the introduction of mezzanine debt and/or AB debt as a positivedevelopment, since certain features of the structures behind such debtprovided additional benefits that were unavailable to lenders in standardbilateral commercial mortgage loan financings. Such benefits may notnecessarily translate into improved credit enhancement levels for loansstructured as AB loans. That being said, it is generally recognised that thestructural features of subordinate debt ensure that a default of the wholemortgage loan does not necessarily result in a shortfall of funds to, andtherefore a default of, the senior loan. In particular, it may be seen that thecure rights of the subordinate lender, the priority of all payments to thesenior loan and the enforcement rights of the senior lender reduce theprobability of default of the whole loan, leading to the conclusion thatsubordinate structures provide benefits to rated classes of bonds in single-loan transactions.

Moreover, as is apparent in the restructuring market that has emerged since2007, whole loan slicing and dicing ultimately creates a variety of interestedparties, (whose interests are often at odds) having a variety of consent andapproval rights over both ‘‘routine’’ mortgage borrower actions such asalterations and lease approvals as well as more complex issues such asmaterial financial modifications. In a whole mortgage loan with multiplepari passu senior tranches, subordinate tranches and possibly mezzanineloans, it is easy to see how a once relatively easy process quickly becomesextremely complicated and convoluted, and will require more time and

10 For further detailed discussions of the servicing standard and the rights and obligations ofthe servicer and the special servicer, see Chs 9, 10 and 11.


123

effort to process, which inevitably leads to increased costs and possiblydelays in restructuring the debt.

While certain deemed consent rights are much more commonplace in aneffort to streamline this process, as we shall see in the following twoChapters, any insolvency proceedings are bound to be infinitely morecomplex, with the potential for large-scale conflict among the various sta-keholders. Nowhere is this more apparent than in the market conditionswitnessed since 2008. In the post GFC market that exists at the time ofwriting, workouts and stressed properties are more apparent than in thelast decade and the role of the intercreditor in such workouts are usuallynot viewed as a productive outcome to the innovative structuring that hasdeveloped over the last few years, as the parties to the intercreditor attemptto agree what rights they thought they had.

In past real estate cycles,11 a mortgage borrower may have only had tonegotiate with one secured creditor, a mortgage bank or at worst a smallsyndicate of such banks. With the continued popularity of utilising sub-ordinate debt in a transaction, the economic tightrope is walked by manyinterested parties—hedge funds, distressed debt funds or opportunistic‘‘vulture’’ funds, even borrower or sponsor affiliates together withnumerous lawyers representing each of the parties. In the end, only timewill tell if the overall impact slicing and dicing, and the effect of inter-creditor arrangements, have had a detrimental impact on mortgage bor-rowers, originating lenders, the restructuring of commercial mortgage andCMBS loans and commercial mortgage loan servicing in general. What iscertain is subordinate debt and the intercreditors that are required todocument such structures are here to stay.

11 See Chs 1 and 2.


124

the commercial mortgage loans and cmbs markets: … · the commercial mortgage loans and cmbs...

Documents